Euro Area
Highlights Global High-Yield: The widening of US Caa-rated high-yield spreads is narrowly focused in Energy-related companies. The conditions for a spillover into the broader junk bond market (tight monetary policy, tightening lending standards & deteriorating corporate health) are not currently in place. Stay overweight high-yield in both the US and euro area, where Caa-rated spreads have also widened. Australia: A sluggish economy and soggy inflation, with little evidence of an imminent turnaround, imply that the Reserve Bank of Australia may not be done with its rate cutting cycle. Maintain an overweight stance on Australian sovereign debt relative to global benchmarks. Feature There’s Nothing To “Caa” Here The clouds of pessimism on global growth, and financial markets, continue to slowly dissipate. The global manufacturing PMI has clearly bottomed, our rising global leading economic indicator is signaling more upside for the first half of 2020, equity markets worldwide are grinding higher, volatility is subdued, while corporate credit spreads in the US and Europe remain generally tight. Yet within the corporate bond market, a peculiar dynamic has emerged. We do not see a reason to extrapolate the weakness in lower-rated US junk bonds into a broader macro issue for the corporate bond market, and the US economy. The option-adjusted spread (OAS) for the overall Bloomberg Barclays US high-yield (HY) index now sits at 376bps. While this spread is relatively narrow from a longer-term perspective, investors may have become more discerning about credit risk. Lower-rated HY has dramatically underperformed higher-rated HY debt of late, with the US Caa-rated OAS now sitting at 985bps compared to Ba-rated spreads of 196bps (Chart of the Week). The divergence across credit tiers is unprecedented, in that Caa spreads are widening while Ba spreads are narrowing – typically, spreads move in tandem directionally, both in bull and bear markets for US junk bonds. The widening of US Caa-rated junk bond spreads has started to raise concerns that this is a “canary in the coal mine” signaling future financial stress among US corporate borrowers. Yet the same dynamic is occurring in euro area HY, with Caa-rated and Ba-rated spreads tracking the US on an almost tick-for-tick basis. In a report published yesterday, our colleagues at BCA Research US Bond Strategy investigated the history of Caa spread widenings dating back to 1996.1 They noted that Caa spread widening has typically been a good predictor of one-year-ahead negative excess returns for the overall US junk bond index. However, there has never been a period like today where Caa spreads have widened while overall HY spreads have remained stable. Chart of the WeekSome Odd Divergences In Global Credit We do not see a reason to extrapolate the weakness in lower-rated US junk bonds into a broader macro issue for the corporate bond market, and the US economy, for two main reasons: Chart 2Lower Energy Prices Hurt Lower Rated US HY 1) The widening is focused on Energy related debt The widening of US Caa-rated spreads in 2019 has occurred alongside a parallel increase in the spreads of Energy-related companies in the US junk bond universe (Chart 2). A similar trend played out during the 2014/15 HY bear phase, which was triggered by the collapse of world oil prices that ravaged the US shale oil industry which dominated the lower-rated tiers of the junk bond market. In 2019, oil prices have declined, although not as dramatically, and HY Energy spreads have widened but to nowhere near the levels seen five years ago. More importantly, non-Energy junk spreads remain very subdued and stable, unlike the case in 2014/15 (bottom panel). When looking at the 2019 year-to-date excess returns for the Bloomberg Barclays US HY index, it is clear that the overall negative returns for the Caa-rated bucket have been driven by the lagging performance of Energy names (Chart 3). The rest of the market has generally been delivering solid excess returns. Chart 3Contribution To 2019 YTD US HY Excess Returns* 2) The widening has not been confirmed by signals from other reliable credit cycle indicators We believe that, from a top-down macro perspective, corporate credit performance in the US is influenced by three main factors: the state of US corporate health, the stance of the Fed’s monetary policy and the trend in lending standards for US banks. We have dubbed this our “Credit Checklist”, and we present a version of that checklist for US high-yield in Chart 4. Chart 4Conditions Not In Place For A Broad US HY Selloff Our “bottom-up” US HY Corporate Health Monitor (CHM) aggregates, for a sample set of US HY issuers, published financial ratios that are typically used to determine the creditworthiness of borrowers – measures like interest coverage, operating margins and leverage. The US HY CHM is currently at a “neutral” reading (2nd panel), unlike past periods where Caa-rated spreads widened sharply: during the early 2000s telecom bust, the 2008 Financial Crisis and the 2014/15 collapse in oil prices. The readings for the three components of our US HY Credit Checklist are all at neutral levels, suggesting that there is no fundamental underpinning at the moment for a sustained increase in US HY spreads. Yet another reason why the latest widening of Caa-rated spreads looks unusual. Turning to measures of the stance of US monetary policy, we look at both the slope of the US Treasury curve (2-year vs 10-year) and the gap between the real fed funds rate and the New York Fed’s estimate of the neutral “r-star” rate. Prior to the early 2000s and 2008 blowout in Caa spreads, the Fed had pushed the real funds rate into restrictive territory above r-star, and the Treasury curve subsequently inverted. That was not the case during the 2014/15 Caa widening, as the Fed was only beginning to transition away from its QE/zero-rate era at that time. Currently, the real funds rate is right at r-star, and the Treasury curve is very flat but not inverted, indicating a broadly neutral monetary policy stance. Finally, we look at data from the Fed’s Senior Loan Officer Survey to evaluate lending standards for US banks. On that front, the latest reading on standards for commercial and industrial loans showed a very modest tightening in the third quarter of 2019, but the overall level remains broadly neutral – unlike the sharp tightening of conditions seen in the early 2000s and 2008 (and the modest tightening in 2014/15). The readings for the three components of our US HY Credit Checklist are all at neutral levels, suggesting that there is no fundamental underpinning at the moment for a sustained increase in US HY spreads. Yet another reason why the latest widening of Caa-rated spreads looks unusual, rather than a sign of future stress in US credit markets. We even see a similar dynamic at work in the euro area. In Chart 5, we present a Credit Checklist for euro area HY, using the same indicators that go into our US HY Credit Checklist. The readings here are even more positive for corporate credit performance than in the US. Our euro area bottom-up HY CHM is showing no deterioration of euro area corporate health, the real ECB policy rate is well below the estimate of r-star, the German yield curve is not inverted and the ECB’s survey of euro area bank lending standards showed a modest easing in the third quarter. Just like in the US, the fundamental backdrop does not argue for a sustained period of euro area HY spread widening, making the latest move higher in euro area Caa spreads as unusual as the move in US Caa. We cannot even blame lower oil prices for the spread widening, as Energy represents only a tiny fraction of the euro area HY market, compared to the large weighting of Energy borrowers in the US junk bond universe. Chart 5Conditions Not In Place For A Broad European HY Selloff We suspect that the correlation between US and euro area HY spreads, by credit tier, has more to do with the increased correlation of trading within global credit markets. Or perhaps it is a sign of investors staying cautious and staying up in quality, even within the riskier HY market. Whatever the reason, we see little fundamental reason to expect the widening of Caa-rated spreads to leak into the broader high-yield market. In fact, if oil prices begin to move higher again, as our commodity strategists are expecting for 2020, that might create a tactical buying opportunity in Caa-rated junk bonds in both the US and euro area. In the meantime, we see no reason to change our recommended overweight stance on US and euro area HY corporate bonds, even with the widening of lower-rated spreads. Bottom Line: The recent widening of US Caa-rated high-yield spreads is narrowly focused in Energy-related companies. The conditions for a spillover into the broader junk bond market (tight monetary policy, tightening lending standards & deteriorating corporate health) are not currently in place. Stay overweight high-yield in both the US and euro area, where Caa-rated spreads have also widened. Australia: The RBA May Not Be Done Yet The rally in Australian government bonds has been driven by the dovish policy response from the Reserve Bank of Australia (RBA) to weak economic growth and tepid inflation – a backdrop that is showing little sign of reversing quickly. We have maintained a recommended overweight investment stance on Australian government bonds since December 19, 2017. Since then, the yield on Bloomberg Barclays Australian Treasury index has declined by -140bps, sharply outperforming bonds in the other developed markets and ending Australia’s long-time status as a “high-yielding” developed economy bond market (Chart 6). The rally in Australian government bonds has been driven by the dovish policy response from the Reserve Bank of Australia (RBA) to weak economic growth and tepid inflation – a backdrop that is showing little sign of reversing quickly. The central bank has already cut interest rates by 75bps this year, taking the Cash Rate down to a record low of 0.75%. At the November 5th monetary policy meeting, the RBA held off on additional easing but still delivered what was perceived by the market to be a dovish surprise, emphasizing persistently below-target inflation and potential downside risks stemming from the housing market. The door was kept wide open for further rate cuts, if necessary. RBA Governor Philip Lowe has even discussed the possibility that the RBA may have to cut rates to the zero bound and start buying assets via quantitative easing to try and restore inflation back to the midpoint of the RBA’s 2-3% target band. Chart 6Australian Bonds Have Outperformed Sharply The RBA’s dovishness is justified, given sluggish economic growth and tepid inflation. Real GDP growth slowed sharply in the first half of 2019 to a meager 1.4% on a year-over-year basis (Chart 7). Consumer sentiment and business confidence remain depressed, having both declined since the start of the year. The former is being hit by weak house prices and sub-par income growth, while the latter is suffering under the weight of weaker demand from Australia’s most important trade partner, China. In addition, persistent drought conditions in much of the country have pushed up food prices and brought down incomes related to the farming sector. Chart 7Sluggish Australian Domestic Demand Chart 8From Boom To Bust In Australian Housing A bellwether for the Australian economy, the housing market, has not fared much better (Chart 8). Building approvals for new dwelling units have fallen almost 20% since September of last year, while house prices in the major cities have been contracting since the fourth quarter of 2017. Responding to easy financial conditions in Australia and the rest of the world, the standard variable mortgage rate has now fallen to a 60-year low. It remains to be seen how quickly the housing market will turn around and when that, in turn, will lift dwelling investment, but the RBA cuts in 2019 should give a bit of a lift to Australian housing in 2020. As in other developed markets, trade uncertainty and fears of a recession have made Australian firms more hesitant to invest. Real private business investment is now falling in year-over-year terms, even with the boost to the terms of trade (and corporate profits) from the increase in prices for Australia’s most important commodities seen in 2019 (Chart 9). That impact may be starting to fade, however. The price for iron ore – a major Australian commodity export – has already fallen 28% from the 2019 peak. In addition, Chinese iron ore imports from Australia are contracting in year-over-terms, even with Chinese growth starting to show signs of stabilization in response to stimulus measures implemented earlier this year. Those is an ominous signal for Australian growth, given the massive swing in net exports seen this year. Chart 9Terms Of Trade Turning Negative For Australian Capex Chart 10An Unsustainable Lift From Net Exports Driven by the persistent depreciation of the Australian dollar, and supportive terms of trade, the Australian trade balance has reached its highest value as a percent of nominal GDP (3.7%) since 1959, when quarterly data began (Chart 10). The surge has come almost entirely from the export side, occurring alongside the boost to commodity prices that was concentrated in iron ore, and looks both unsustainable and unrepeatable on a rate-of-change basis. Slowing Australian economic momentum has also impacted the labor market. Employment growth is slowing and the unemployment rate has ticked up to 5.3% from a cyclical low of 5% in February 2019 (Chart 11). The so-called “underemployment rate”, is a much higher 8.5%, indicating that there is still ample slack in the Australian labor market as workers are working fewer hours than they wish (and are hence, “underemployed”). The underemployment rate is negatively correlated to wage growth, suggesting that the modest upturn in the latter seen since the end of 2016 is likely to cool off (bottom panel). Chart 11Some Softening In The Australian Labor Market Chart 12Australian Inflation Remains Subdued The RBA has already warned that wage growth expectations may have become anchored at a lower level given the anemic growth over the past several years. That mirrors the trend seen in overall price inflation. Headline CPI inflation was only 1.6% in the third quarter of 2019, as was the “trimmed mean” CPI inflation rate that is favored by the RBA. Both are below the bottom end of the RBA’s target range of 2-3%, as are survey-based expectations of short-term inflation (Chart 12). The previously mentioned drought conditions have put some upward pressure on overall inflation via grocery food prices, but that is expected to be transitory. With depressed house prices and ongoing issues with spare capacity in the labor market, longer-term market-based inflation expectations, captured by the 5-year/5-year forward CPI swap rate, have dipped below the 2% level. The combination of weakening growth and soggy inflation poses a problem for the RBA, as it tries to use monetary policy tools to reverse those trends at a time when Australian banks have seen an unprecedented level of scrutiny of their lending practices. Australian banks have been under the harsh political spotlight after the government’s Royal Commission on misconduct in the financial industry released its findings back in February of this year. Many banks were exposed for serious violations, including money laundering and “improperly” selling financial products to households. Several top bank executives lost their jobs as a result, with the overall industry duly chastised and humbled. Australian banks remain well capitalized, following the path of most developed market banks in response to the Basel III reforms, while non-performing loans remain modest. Yet the risk moving forward is that Australian banks become more prudent in their lending practices after the public “flogging” they received this year, which may impair the transmission mechanism from low RBA policy rates to increased loan growth - and, eventually, faster economic activity. Already, private credit growth has slowed sharply, with the sharpest declines coming for housing and business lending (Chart 13). Investment implications for Australian bonds In the case of Australia, however, the underlying economy and inflation trends still point to a possibility that the RBA will have to ease again sometime in the next few months – a move that is unlikely to be matched in the other major developed markets. This likely means that Australian government bonds can continue to outperform in 2020. Despite signs that the global economy is starting to bottom out after the 2019 downturn, the momentum in Australian economic growth and inflation remains tepid. This suggests that Australian sovereign debt is likely to continue outperforming global peers on a relative basis over the next 6-12 months. Our RBA Monitor continues to signal that more interest rate cuts from the RBA are needed. Yet the Australian Overnight Index Swap (OIS) curve now discounts only 19bps of rate cuts over the next year (Chart 14). This mirrors the trend seen in other developed interest rate markets, as investors have shifted to pricing out the dovish policy expectations as global growth starts to improve. Chart 13Weakening Loan Demand, But No Credit Crunch Chart 14Stay Overweight Australian Government Bonds In the case of Australia, however, the underlying economy and inflation trends still point to a possibility that the RBA will have to ease again sometime in the next few months – a move that is unlikely to be matched in the other major developed markets. This likely means that Australian government bonds can continue to outperform in 2020. We advise staying strategically overweight Australian government bonds in global fixed income portfolios. Bottom Line: A sluggish economy and soggy inflation, with little evidence of an imminent turnaround, imply that the Reserve Bank of Australia may not be done with its rate cutting cycle. Maintain an overweight stance on Australian sovereign debt relative to global benchmarks. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Shakti Sharma Research Associate ShaktiS@bcaresearch.com Footnotes 1 Please see BCA Research US Bond Strategy Weekly Report, “Caa-Rated Bonds: Warning Sign Or Buying Opportunity?”, dated November 26, 2019, available at usbs.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Dear Client, In addition to this short weekly report, you will also receive our 2020 outlook, published by the Bank Credit Analyst. Next week, I will be on the road visiting clients in South Africa. I hope to report my discussions and findings the following week. Best regards, Chester Ntonifor Highlights According to a simple attractiveness framework, the most desirable currencies are the Norwegian krone, the Swedish krona, and the Japanese yen. The least attractive are the New Zealand dollar and the British pound. Take profits soon on our long GBP/JPY position. Feature In this report, we use a simple framework for ranking G10 currencies. First, we consider the macroeconomic environment using as proxies a country’s basic balance and external vulnerability. Next, we look at valuation metrics, surveying a variety of both short-term and longer-term models. Finally, we consider positioning, to gauge if our view is mainstream or out of consensus. Below are our results. Basic Balance Chart I-1Basic Balance We consider the basic balance to be one of the most important concepts in determining the attractiveness of a currency. In a nutshell, it captures the ebb and flow of demand for a country’s domestic assets. Persistent basic balance surpluses are usually associated with an appreciating currency and vice versa. The euro area sports the best basic balance surplus in the G10 universe, followed by Norway and then Australia (Chart I-1). In simple terms, this means there is constant strong underlying demand for these currencies - either for domestic goods and services, or for investment into portfolio assets. The UK and the US rank the worst in terms of basic balances, driven by Brexit uncertainty and the ebbing of tax reform benefits in the US. We will explore balance of payments dynamics within all of the G10 countries in detail next week. External Debt A currency is sometimes only as vulnerable as its external liabilities. In an absolute sense, external debt as a share of GDP is highest in the UK, euro area, and Switzerland (Chart I-2). However, what matters most times for vulnerability are net external assets rather than gross liabilities. On this measure, Japan, Switzerland, and Norway are the most attractive countries, while the US and Australia rank the worst (Chart I-3). Chart I-2External Vulnerability Chart I-3US Is Least Attractive Purchasing Power Parity (PPP) Chart I-4PPP Model Various models have shown PPP to be a very poor tool for managing currencies, but an excellent one at extremes. However, there is a roadblock that comes from measurement issues, since consumer price baskets tend to differ in composition from one country to the next. In order to get closer to an apples-to-apples comparison across countries, two adjustments are necessary. First, categorizing the consumer price index (CPI) into five major groups. In most cases, this breakdown captures 90% of the national CPI basket. This includes food, restaurants and hotels (1), shelter (2), health care (3), culture and recreation (4), and energy and transportation (5). The second adjustment is to run two regressions with the exchange rate as the dependent variable. The first regression (call it REG1) uses the relative price ratios of the five groups as independent variables. This allows us to observe the most influential price ratios that help explain variations in the exchange rate. The second regression (call it REG2) uses a weighted average combination of the five groups to form a synthetic relative price ratio. If, for example, shelter is 33% in the US CPI basket, but 19% in the Swedish CPI basket, relative shelter prices will represent 26% of the combined price ratio. This allows for a uniform cross-sectional comparison, as opposed to using the national CPI weights. The US dollar is overvalued, especially versus the Swedish krona, Japanese yen, and Norwegian krone. The results show the US dollar as overvalued, especially versus the Swedish krona, Japanese yen, and Norwegian krone. Commodity currencies are closer to fair value, and within the safe-haven complex, the Japanese yen is more attractive than the Swiss franc. The euro is less undervalued than implied by the overvaluation in the DXY index (Chart I-4). Intermediate-Term Timing Model (ITTM) Back in 2016, we developed a set of currency indicators to help global portfolio managers increase their Sharpe ratio in managing currency exposure. The idea was quite simple: For every developed world country, there were three key variables that influenced the near-term path of its exchange rate versus the US dollar. Our intermediate-term timing models are not sending any strong signals at the moment. Interest Rate Differentials: Under the lens of interest rate parity, if one country is expected to have lower interest rates versus another, the incumbent’s currency will fall today so as to gradually appreciate in the future and nullify the interest rate advantage. Chart I-5Intermediate-Term Model Inflation Differentials: Assuming no transactional costs, the price of sandals cannot be relatively high and rising in Mumbai versus Auckland. Either the Indian rupee needs to fall, the kiwi rise, or a combination of the two has to occur to equalize prices across borders. Risk Factor: Exchange rates are not government bonds in that few treasury departments and central banks can guarantee a par value on them. Ergo, the ebb and flow of risk aversion will have an impact on the Norwegian krone as well as the yen. For the most part, our models have worked like a charm. On a risk-adjusted return basis, a dynamic hedging strategy based on our ITTMs has outperformed all static hedging strategies for all investors with six different home currencies since 2001. These results give us confidence to continue running these models as a sanity check for our ever-shifting currency biases. That said, our intermediate-term timing models are not sending any strong signals at the moment. The Swedish krona, Norwegian krone, and New Zealand dollar are the most attractive currencies, while the British pound and Swiss franc are the least attractive (Chart I-5). Long-Term Fair Value Model Chart I-6Long-Term Model Our long-term FX models are also part of a set of technical tools we use to help us navigate FX markets. Included in these models are variables such as productivity differentials, terms-of-trade shocks, net international investment positions, real rate differentials, and proxies for global risk aversion. These models cover 22 currencies, incorporating both G10 and emerging market FX markets. The models are not designed to generate short- or intermediate-term forecasts. Instead, they reflect the economic drivers of a currency's equilibrium. Their main purpose is to provide information on the longevity of a currency cycle, depending on where we are in the economic cycle. Our long-term FX models are not sending any strong signals right now, with the US dollar at fair value. The cheapest currencies are the yen, the Norwegian krone, and Swedish krona (Chart I-6). The priciest currencies are the South African rand and the Saudi riyal. Real Interest Rates One defining feature of the currency landscape is that pretty much across the G10 countries, we have negative real rates (Chart I-7). Within the G10 universe, the US and New Zealand dollars are the highest-yielding currencies, while the British pound and Swedish krona are the least attractive. Chart I-7Real Rates Speculative Positioning Being long Treasurys and the dollar has been a consensus trade for many years now (Chart I-8). According to CFTC data, this has been expressed mostly through the aussie and kiwi, although our bias is that the Swedish krona and Norwegian krone have been the real victims. Chart I-8Positioning That said, flow data highlights just how precarious being long US dollars is right now. Net foreign purchases by private investors are still positive, but the momentum of these flows is clearly rolling over. This is being more than offset by official net outflows. As interest rate differentials have started moving against the US, so has foreign investor appetite for Treasury bonds. Concluding Thoughts Should the nascent pickup in global growth morph into a synchronized recovery, it will go a long way in further eroding the US’ yield advantage. More specifically, the currencies that have borne the brunt of the manufacturing slowdown should also experience the quickest reversals. For example, yields in Norway, Sweden, Switzerland, and Japan have risen by much more than those in the US since the bottom. The most attractive currencies are the Swedish krona, the Norwegian krone, and the Japanese yen. The least attractive are the British pound and New Zealand dollar. This is the message being sent by an aggregate of our ranking model. The most attractive currencies are the Swedish krona, the Norwegian krone, and the Japanese yen. The least attractive are the British pound and New Zealand dollar (Chart I-9). Take profits soon on our long GBP/JPY position. Chart I-9Favor Norway, Japan and Sweden Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the US have been mixed: Retail sales grew by 0.3% year-on-year in October. Industrial production contracted by 0.8% month-on-month in October. On the housing market front, building permits and housing starts both increased by 5% and 3.8% month-on-month in October. However, MBA mortgage applications contracted by 2.2% for the week ended November 15th. The NY Empire State Manufacturing index fell to 2.9 from 4 in November. The Philly Fed manufacturing index, on the other hand, soared to 10.4 from 5.6 in November. The DXY index depreciated by 0.3% this week. The FOMC minutes released this Wednesday showed that the Fed now sees little need to further reduce rates. Last week, we did a reassessment of global growth and the USD, and entered a limit sell for the DXY index at 100. Report Links: Place A Limit Sell On DXY At 100 - November 15, 2019 Signposts For A Reversal In The Dollar Bull Market - November 1, 2019 On Money Velocity, EUR/USD And Silver - October 11, 2019 The Euro Chart II-3EUR Technicals 1 Chart II-4UR Technicals 2 Recent data in the euro area have been mostly positive: The seasonally-adjusted trade balance fell to €18.3 billion in September. The current account surplus slightly narrowed by €0.3 billion to €28.2 billion. Headline and core inflation were both unchanged at 1.1% and 0.7% year-on-year respectively in October. Consumer confidence improved from -7.6 in October to -7.2 in November. EUR/USD increased by 0.5% this week. The improvement in soft data confirms that the economy is in a bottoming process in the euro area. The fact that the largest economy, Germany, skirted a recession last week also boosted investor confidence. We continue to remain overweight the euro. Report Links: On Money Velocity, EUR/USD And Silver - October 11, 2019 A Few Trade Ideas - Sept. 27, 2019 Battle Of The Central Banks - June 21, 2019 Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been positive: Exports decreased by 9.2% year-on-year in October. Imports slumped by 14.8% year-on-year. The total trade balance shifted to a surplus of ¥17.3 billion. The industry activity index increased by 1.5% month-on-month in September. USD/JPY fell by 0.2% this week. While global growth is set to improve given a possible trade détente and easy monetary policy worldwide, uncertainties continue to loom. The US Senate unanimously passed legislation on the "Hong Kong Human Rights and Democracy Act," adding more difficulties to finalize the Phase I trade deal. Global trade uncertainty is positive for safe-haven demand. Report Links: Signposts For A Reversal In The Dollar Bull Market - November 1, 2019 A Few Trade Ideas - Sept. 27, 2019 Has The Currency Landscape Shifted? - August 16, 2019 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the UK have been positive: The Rightmove house price index increased by 0.3% year-on-year in November. Public sector net borrowing increased by £3 billion to £10.5 billion in October. The British pound continues to appreciate by 0.7% against the US dollar this week. With Brexit being less of a threat, the pound is poised to rise through next year. We are long GBP/JPY in our portfolio and it is in the money at 6.1%. Report Links: A Few Trade Ideas - Sept. 27, 2019 United Kingdon: Cyclical Slowdown Or Structural Malaise? - Sept. 20, 2019 Battle Of The Central Banks - June 21, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia have been soft: The Westpac leading index fell by 0.1% month-on-month in October, following a slight decline the previous month. AUD/USD has been more or less flat this week. In the monetary policy minutes released this week, the RBA expressed their expectations for stronger growth at 2.75% in 2020 and around 3% in 2021, supported by accommodative monetary policy, infrastructure spending, stabilizing house prices, and strong steel-intensive activities in China. The minutes also presented an argument against lower interest rates: while lower interest rates can support the economy through the usual transmission channels, they could be negative for savers and confidence. That said, the RBA is "prepared to ease monetary policy further if needed." Report Links: A Contrarian View On The Australian Dollar - May 24, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Not Out Of The Woods Yet - April 5, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand have been positive: Both output and input components of the producer price index have increased in Q3: the output component grew by 1% quarter-on-quarter and input component by 0.9% quarter-on-quarter. NZD/USD increased by 0.7% this week. Both growth and inflation in New Zealand are showing signs that the economy is in a bottoming process. We are positive on the kiwi against the US dollar while we remain short against the Australian dollar and Swedish Krona. Report Links: Place A Limit Sell On DXY At 100 - November 15, 2019 USD/CNY And Market Turbulence - August 9, 2019 Where To Next For The US Dollar? - June 7, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada have been negative: Manufacturing shipments fell by 0.2% month-on-month in September. Both headline and core inflation were unchanged at 1.9% year-on-year in October. ADP employment showed a loss of 22.6K jobs in October. The Canadian dollar fell by 0.6% against the US dollar this week. While a possible trade détente between US and China and rising oil prices could put a floor under the loonie, the pipeline constraints in Canada have dampened the correlation between the oil prices and the loonie. This will limit the upside potential for the Canadian dollar. Report Links: Making Money With Petrocurrencies - November 8, 2019 Signposts For A Reversal In The Dollar Bull Market - November 1, 2019 Preserving Capital During Riot Points - September 6, 2019 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland have been positive: The trade surplus narrowed to CHF 3.5 billion in October from CHF 4.1 billion the previous month, due primarily to growth in imports, which grew by 1.9 billion month-on-month. Exports also increased by 1.3 billion month-on-month. Import demand remains firm for chemical products. Industrial production grew by 8% year-on-year in Q3. USD/CHF increased by 0.2% this week. The trade balance still remains at a high level in Switzerland, which is bullish for the franc. Moreover, global uncertainties could underpin the safe-haven franc. Report Links: Notes On The SNB - October 4, 2019 What To Do About The Swiss Franc? - May 17, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway have been positive: The trade balance shifted to a surplus of NOK 5.9 billion in October, after a deficit of NOK 1.4 billion in September. However, this is compared to a surplus of NOK 32.6 billion in the same month last year. On a year-on-year basis, exports slumped by 27%, caused by a decrease in exports of mineral fuels and chemical products. The Norwegian krone appreciated by 0.3% against the US dollar this week, supported by the oil price recovery. On Wednesday, the EIA posted an increase of crude oil inventories by 1.4 million barrels from the previous week, lower than expectations. WTI crude oil prices thus surged by 4% on the news. Going forward, we remain overweight energy prices and the Norwegian krone. Report Links: Making Money With Petrocurrencies - November 8, 2019 A Few Trade Ideas - Sept. 27, 2019 Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden have been positive: Capacity utilization increased to 0.5% in Q3, up from 0.1% in the previous quarter. The Swedish krona increased by 0.7% against the US dollar this week. The Swedish krona has depreciated by 23% against the USD since its 2018 peak. A global growth revival is likely to give a boost to the krona from a valuation perspective. Report Links: Where To Next For The US Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades
Highlights Stock markets are set to produce low single digit returns in 2020. Favour stocks over bonds and cash, especially where bond yields are zero or negative – specifically, Germany, Switzerland, and Sweden. Underweight zero and negative yielding high-quality bonds versus higher yielding bonds – for example, underweight Swiss bonds versus US T-bonds. Favour lower yielding currencies because the central bank loses the ability to depress its own currency. For 2020, our preferred expression of this is long SEK/USD. The biggest risk in 2020 is if the global bond yield were to rise towards 2.5 percent exposing the fragility of risk-asset prices to higher bond yields. The $400 trillion global risk-asset edifice dwarfs the $80 trillion global economy by five to one. Fractal trade: Short Ireland (ISEQ 20) versus Europe (Stoxx Europe 600). Feature For all the talk of economic growth driving stock markets, the big story through 2018-19 has been bond yields driving stock markets. This is true in Europe as well as more broadly – and it is very easy to demonstrate by decomposing the stock market price into its two components: the underlying profits (earnings per share) and the valuation multiple paid for those profits (Chart of the Week). Chart of the Week2018 And 2019 Were All About Valuations. What About 2020? 2018 And 2019 Were All About Valuations Contrast 2018-19 with 2017. In 2017, the stock market’s stellar return came almost entirely from growth – profits surged while the multiple drifted sideways. But in 2018 and 2019, the story was all about valuation multiples – profits drifted sideways while the multiple plunged in 2018, and then symmetrically surged in 2019 (Chart I-2 and Chart I-3). Chart I-2Decomposing Stock Market Performance... Chart I-3...Into Valuation And Profits The cause of the stock market multiple contraction and re-expansion was the dramatic swing in bond yields. This is hardly surprising given that the prospective return on bonds drives the prospective return on competing long-duration assets, like equities and real-estate. Higher bond yields require a higher prospective return on equities, meaning a lower valuation multiple, while lower bond yields require a higher valuation multiple. In driving the swing in bond yields, the principal player was the Federal Reserve. Again, this is hardly surprising given that the ECB and BoJ are stuck on the side lines with monetary policy already locked at ‘maximum accommodative’, while the Fed can still move the lever in both directions. The cause of the stock market multiple contraction and re-expansion was the dramatic swing in bond yields. Through 2018-2019, the 10-year T-bond yield took a round trip from around 2 percent to 3.3 percent and then down again to around 2 percent where it stands today. This explains the mirror-image round trip in the stock market’s multiple: from 16 down to 13 and then back up again to 16 where it stands today (Chart I-4). Chart I-4The Round Trip In The T-Bond Yield Explains The Round Trip In The Stock Market's Valuation Admittedly, the Fed’s dramatic pivot was influenced by the trade war, and the perceived threat to global growth. But two other considerations loomed large: the persistent undershoot of inflation versus its 2 percent target; and the fragility of risk-asset valuations – and thereby financial conditions – to higher bond yields. Bear in mind that the value of global risk-assets at over $400 trillion now dwarfs the $80 trillion global economy by a factor of five to one. So the main danger is not that economic imbalances and fragilities will drag down the financial markets; the main danger is that financial market imbalances and fragilities will drag down the economy – as we painfully felt in 2000, 2007, and 2011. The Valuation And Growth Outlook In 2020 The two key investment questions for 2020 are: What will happen to bond yields, and what will happen to stock market profits? Starting with bond yields, most of the major central banks are, to repeat, out of play. Leaving the Fed as the principal player. But at the last press conference, Jay Powell, made it crystal clear that the Fed is also out of play for the time being, at least when it comes to raising rates. “We've just touched 2 percent core inflation, and then we've fallen back. So, I think we would need to see a really significant move up in inflation that's persistent before we even consider raising rates to address inflation concerns.” Reinforcing this, Powell also hinted at introducing a potential ‘tolerance band’ around the 2 percent inflation target – perhaps 1.5-2.5 percent – before the central bank would need to react. “We're also, as part of our review, looking at potential innovations… changes to the framework that would be more supportive of achieving inflation on a symmetric 2 percent basis over time… these changes to monetary policy frameworks don't happen really quickly (but)… I think we'll wrap it up around the middle of next year. I've some confidence in that.” What about profits – could 2020 be a repeat of the 2017 stellar growth story? No, there are two reasons why it will be very difficult to repeat the 2017 story on profits. The two reasons come from the two components of profits: sales and profit margins. Unlike in 2017, global sales will not start 2020 at the very depressed levels from which they can play a very strong catch-up. The first reason is that, unlike in 2017, global sales will not start 2020 at the very depressed levels from which they can play a very strong catch-up (Chart I-5). Significantly, the recession in global sales through 2015-16 was comparable to that suffered in 2008-09. The 2015-16 recession just hasn’t been well documented because it was essentially an emerging markets recession rather than the developed market recession of 2008-09. Chart I-5Global Sales Are Not Depressed The second reason is that today’s profit margins are still close to their structural and cyclical peak; whereas at the start of 2017, they were at a cyclical low (Chart I-6). Chart I-6Profit Margins Are Elevated Hence, the two components of profits – sales and profit margins – will start 2020 at elevated levels. The upshot is that profits can grow in 2020, but the growth will be pedestrian at best. Let’s summarise some of the key investment messages for 2020. High quality bond yields that are near the lower bound of -1 percent cannot go much lower, but those yields in the region of 2 percent cannot go significantly higher. It follows that fixed-income investors should underweight zero and negative yielding bonds versus higher yielding bonds – for example, underweight Swiss bonds versus US T-bonds. In a negative growth shock, T-bonds can still offer substantial capital gains but Swiss bonds cannot. For currencies, it is the opposite message. Favour lower yielding currencies because the central bank loses the ability to depress its own currency. For 2020, our preferred expression of this is long SEK/USD. Stock markets are set to produce low single digit returns. This is uninspiring, but in a world of low prospective returns from all major asset-classes, favour stocks over bonds and cash. This is especially true in those regions and countries where bond yields are zero or negative – specifically, Germany, Switzerland, and Sweden. Today’s profit margins are still close to their structural and cyclical peak The biggest risk to this view is if the global bond yield were to rise towards 2.5 percent exposing the fragility of the risk-asset edifice to higher bond yields. To repeat, the value of global risk-assets, at over $400 trillion, dwarfs the $80 trillion global economy. So the biggest risk comes from the valuation of global financial markets, it does not come from the global economy. More About Price To Sales Having completed our 20 paragraphs on 2020, we would like to follow up on the analysis in last week’s report: Are European Stocks Attractive? To recap, we found that price to sales is the stock market valuation metric that has the best predictive power for prospective returns – because unlike other metrics such as assets, profits, and cash flow, sales are quantifiable, unambiguous, and undistorted by profit margins. In last week’s report our prospective return forecasts were based on price to sales data sourced from Thomson Reuters. To which, several clients asked if the analysis would be the same using the price to sales data sourced from MSCI (Chart I-7). The answer is broadly yes. Chart I-8-Chart I-10 illustrate that: Chart I-7Despite The US, Germany, And Japan Trading On Different Valuations... Chart I-8...The Prospective Return From The US Is Low Single Digit... Chart I-9...The Prospective Return From Germany Is Low Single Digit... Chart I-10...The Prospective Return From Japan Is Low Single Digit... First, despite vastly different stock market valuations in Germany, Japan, and the US, the implied prospective 10-year annualised returns are almost identical. Second, the implied prospective returns from the MSCI calculated price to sales are slightly lower than from the Thomson Reuters data, because current MSCI valuations are closer to the dot com bubble peak. Third, this just reinforces the point that stock market valuations are very fragile to higher bond yields, as already discussed in our preceding 20 paragraphs on 2020. Fractal Trading System* This week we note that the strong outperformance of the Irish stock market is vulnerable to a correction based on its broken 65-day fractal structure. Accordingly, this week’s recommended trade is short Ireland (ISEQ 20) versus Europe (Stoxx Europe 600). Set the profit target and symmetrical stop-loss at 4 percent. In other trades, we are pleased to report that long gold versus nickel achieved its 11 percent profit target and is now closed. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com. Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading System Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations
Highlights The attractiveness of European stocks is relative to European bonds rather than relative to non-European stocks. Despite vastly different stock market valuations in Germany, Japan, and the US, the implied prospective 10-year annualised returns are almost identical – at around 5 percent per annum. Overweight the DAX versus German long-dated bunds. Equities would lose their attractiveness if the global 10-year bond yield were to rise through 2.5 percent, because the required excess return from equities would viciously normalise. Tactically overweight EM versus DM. Fractal trade: short GBP/NOK, as the recent rally in the pound appears technically extended. Feature Chart of the WeekOverweight Europe Vs. World = Overweight Consumer Staples Vs. Technology Stock markets recently broke to new highs, begging the perennial question: how attractive are equities at current valuations? To answer, we need to assess the prospective return that is now ‘baked in the equity valuation cake’. But which valuation metric gives the most credible assessment of prospective returns? Equity valuations based on assets are problematic – because nowadays, assets comprise intellectual capital or intangibles or ‘virtual’ assets, which are extremely difficult to value. Equity valuations based on earnings are problematic. Equity valuations based on earnings (profits) are also problematic – because they take no account of structurally high profit margins (Chart I-2). The problem is that earnings will face a headwind when profit margins normalise, depressing prospective returns. Some people suggest adjusting the earnings to derive a cyclically adjusted price to earnings multiple (CAPE), but by definition this does not correct for the structural rise in profit margins. Chart I-2Structurally High Profit Margins Flatter Earnings Hence, the most credible assessment comes from price to sales – because sales are quantifiable, unambiguous, and undistorted by profit margins. Significantly, while price to earnings missed the high valuation of world equities in 1990 (Japanese bubble) and 2007 (credit bubble), price to sales did not (Chart I-3 and Chart I-4). Chart I-3Price To Earnings Missed The Japanese Bubble And The Credit Bubble... Chart I-4...But Price To Sales ##br##Didn't Are Stocks Attractive? Based on the credible assessment from price to sales, today’s prospective 10-year annualised return from world equities is around 5 percent (Chart I-5). This is not that different to the 4 percent prospective return at the peak of the credit bubble in 2007.1 Which raises an obvious question. Back in 2007, a secular growth boom provided the excuse for the rich absolute valuation, but today, if anything, investors fear a ‘secular stagnation’. What can excuse today’s rich absolute valuation? Chart I-5The Prospective Return From World Equities Is 5 Percent The answer is ultra-low bond yields. In 2007, the global 10-year bond yield stood at 5 percent; today, it stands well below 2 percent (Chart I-6). A lower prospective return on bonds means a lower prospective return on competing long-duration assets, like equities. Chart I-6The Global 10-Year Bond Yield Has Plunged To Below 2 Percent Moreover, as bond yields approach their lower bound, the riskiness of bonds rises because they take on an unattractive ‘lose-lose’ characteristic. As holders of Swiss government bonds discovered this year, prices do not rise much in a rally, but they do plunge in a sell-off. This higher riskiness of bonds justifies an abnormally low (or zero) ‘risk premium’ on competing long-duration assets, like equities. The 5 percent prospective return makes equities look attractive relative to bonds. The upshot is that the 5 percent prospective return from equities is low in absolute terms. But in a world of ultra-low numbers – for both bond yields and equity risk premiums – the 5 percent prospective return makes equities look attractive relative to bonds. At the peak of the credit bubble in 2007, equities were offering a lower prospective return than the 5 percent available from bonds. But today’s equity risk premium over bonds is generous. The caveat is that this would change if the global 10-year bond yield were to rise through 2.5 percent because the required risk premium on equities would viciously normalise. Are European Stocks Attractive? Turning to the relative attractiveness of major stock markets, it is tempting to think that the markets trading on the best head-to-head valuation comparisons are the most attractive. For example, Germany and Japan, both trading on a price to sales multiple of 0.9, appear compelling buys compared to the US, trading on a multiple of 2.1 (Chart I-7). But such a knee-jerk conclusion is wrong, for two reasons. Chart I-7Germany And Japan Trade On Much Lower Multiples Than The US First, stock markets have very different sector compositions. Two sectors with vastly different structural growth prospects – say, technology and banks – must necessarily trade on vastly different valuations. So the sector with the lower valuation is not necessarily the better-valued sector. By extension, the stock market with the lower valuation because of its ‘sector fingerprint’ is not necessarily the better-valued stock market. Second, major stock markets are dominated by multinational companies with mixed currency sales and profits, while the stock price is quoted in the domestic currency. Hence, if the market expects the mixed currency profits to depreciate in domestic currency terms, the stock will trade at a discount. Put another way, if the domestic currency is cheap the stock market will appear cheap. The best way to see this is to look at the two valuations of dual-listed multinationals like the UK/US cruise operator Carnival. In London, the stock trades on a price to forward earnings at 9.7; in New York it trades at 10.3. But it would be absurd to suggest that Carnival is cheaper in London than in New York! The discrepancy is simply because the market expects the pound to appreciate versus the dollar. A head-to-head comparison of stock market valuations is misleading. Allowing for the distortions from sector skews and currency adjustments, the best way to assess an equity region’s attractiveness is to quantify the prospective return implied by its valuation versus its own history. The method is to regress historic starting price to sales with the (historic) prospective 10-year returns that followed. Then apply this relationship to the current price to sales to predict the (current) prospective 10-year return. The results are amazing. Despite the vastly different price to sales multiple of 0.9 in Germany and Japan, and 2.1 in the US, the implied prospective 10-year annualised returns are almost identical – at around 5 percent from each of the three stock markets (Chart I-8-Chart I-10). Chart I-8Expect Near-Identical Returns From The US... Chart I-9…Germany… Chart I-10...And Japan Still, there is one significant difference: the 10-year bond yield is much lower in Germany and Japan than in the US, equating to a much more attractive equity risk premium of over 5 percent in Germany and Japan. So to answer this week’s title, yes, European stocks are attractive. But the attractiveness is not relative to non-European stocks, the attractiveness of European stocks is relative to European bonds. Bottom Line: maintain a structural overweight to the DAX versus German long-dated bunds. Europe’s ‘Sector Fingerprint’ Is No Longer Pro-Cyclical Over the short term, stock market relative performance is just the result of global sector relative performance combined with the unique sector fingerprint of each stock market. It follows that regional and country equity allocation must always start with a sector view combined with an awareness of the sector fingerprint of the major bourses (Table 1-1). Table I-1EM, DM, And Europe Have Unique ‘Sector Fingerprints’ In this regard, there is an important change. Market action plus index composition changes are making the European index less cyclical. Specifically, the European index is no longer over-weighted to Financials relative to the world index. Instead, the European sector fingerprint is now: ‘Overweight Consumer Staples, Underweight Technology’ (Chart of the Week). With the overweight skew being to defensive staples and the underweight skew to partly-cyclical tech, the cyclicality of the European index has become ambiguous. By contrast, emerging market (EM) equities remain ultra-cyclical with a sector fingerprint that is: ‘Overweight Banks, Underweight Healthcare’ (Chart I-11). Suffice to say, this is ultra-cyclical because the 10 percent overweight is to an unambiguously cyclical sector, while the symmetrical 10 percent underweight is to an unambiguously defensive sector. Chart I-11Overweight EM Vs. DM = Overweight Banks Vs. Healthcare The upshot is that a pro-cyclical sector tilt no longer implies an overweight to European equities versus other regions, but it does strongly imply an overweight to EM equities. This is our recommended stance, albeit only on a tactical horizon until our leading indicators show that the current growth rebound can be sustained well into 2020. Stay tuned. Fractal Trading System* The broken 65-day fractal structure of GBP/NOK suggests that its recent rally is susceptible to a countertrend sell-off, albeit UK election campaign developments are likely to be the near-term sentiment drivers. Go short GBP/NOK, setting a profit target at 2.5 percent with a symmetrical stop-loss. In other trades, short Italian 10-year BTP achieved its 3 percent profit target and is now closed, while long gold / short nickel is very close to its 11 percent profit target. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com. Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 Total (capital plus income) nominal annualised returns Fractal Trading System Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations
Our bottom-up euro area Corporate Health Monitors are sending different messages for lower-rated and higher-quality issuers. For euro area investment grade, the gap between domestic and foreign issuers has been widening, with the former now in “deteriorating…
Highlights The mood among investors is shifting from the recessionary gloom of this past summer. Equities worldwide are rallying, buoyed by a combination of dovish monetary policies, tentative signs of bottoming global growth and expectations of some sort of trade détente between the US and China. The latter is fueling more bullish sentiment towards equities in regions most exposed to global trade and manufacturing like Emerging Markets (EM) and Europe. Feature Chart 1Global Corporates: 2016 Revisited? Credit investors, in an unusual twist, have been far more optimistic than their equity brethren. Corporate bonds have delivered solid performance in 2019, with the Bloomberg Barclays Global Corporates total return index up +9.5% year-to-date. This is a surprising development, as global growth concerns triggered a major decline in developed market government bond yields but no widening of credit risk premia (Chart 1). With that in mind, this week we are presenting the latest update of our Corporate Health Monitor (CHM) Chartbook. The CHMs are composite indicators of balance sheet and income statement ratios (using both top-down and bottom-up data) designed to assess the financial well-being of the overall non-financial corporate sectors in the major developed economies. A brief overview of the methodology is presented in Appendix 1 on page 15. The overriding message from the latest read of our CHMs is that the manufacturing-led slowing of global growth this year has not resulted in much deterioration in overall corporate creditworthiness. There are fascinating cross-currents within the data, however. On a regional basis, the CHMs in the euro area, the UK and Canada are in better shape than in the US and Japan. The most interesting differences are across credit quality, with our “bottom-up” high-yield (HY) CHMs looking better than the investment grade (IG) equivalents in both the US and euro area, mostly due to greater relative increases in IG leverage. Our current global corporate bond investment recommendations broadly follow the trends signaled by our CHMs: an aggregate overweight stance versus global government debt, but with a “reverse quality bias” favoring HY over IG in the US and Europe. With government bond yields now on the rise across the developed markets – and with credit spreads fairly tight across the majority of countries - the period of hyper-charged absolute corporate bond returns is over. Expect more carry-like excess returns over sovereigns during the next 6-12 months. US Corporate Health Monitors: Steady Deterioration, Mostly Within Investment Grade Our top-down US CHM is sending a negative message on credit quality, staying in the “deteriorating health” zone since 2015 (Chart 2). The structural declines in the profitability ratios (return on capital and operating margin), debt coverage and, more recently, short-term liquidity are the main causes of that deterioration in US corporate health. Not all the news is negative, however. While operating margins have clearly peaked, they remain at a very high level. The top-down interest coverage ratio is also improving, thanks to low corporate borrowing rates. That is a welcome development that will help extend the US credit cycle by keeping downgrade/default risk, and the credit spreads required to compensate for it, subdued. When looking at our bottom-up US CHMs, the story becomes more nuanced. The bottom-up US high-yield CHM is signaling a surprisingly positive story, spending the past two years in “improving health” territory. The bottom-up US IG CHM remains above the zero line, as has been the case since 2012 (Chart 3). The multi-year increase in the debt-to-equity ratio, and declines in return on capital and interest coverage over the same period, are the main reasons why US IG corporate health has worsened, even as profit margins have stayed high. Chart 2Top-Down US CHM: Steadily Worsening Chart 3Bottom-Up US IG CHM: Some Areas Of Concern The bottom-up US HY CHM is signaling a more positive story, spending the past two years in “improving health” territory (Chart 4), led by stable balance sheet leverage and improvements in operating margins and return on capital. The absolute levels of interest and debt coverage ratios for US HY remain low – a potential future risk for US HY when the US economy goes into its next prolonged downturn. One common signal from all our US CHMs, both top-down and bottom-up, is that short-term liquidity ratios have declined. Those moves are driven by increases in the denominator of the ratios (the market value of assets for the top-down CHM, and the value of current liabilities in the bottom-up CHMs), rather than declines in working capital or cash on corporate balance sheets – trends that would typically precede periods of corporate distress. Just last week, we downgraded US IG to neutral, while maintaining an overweight tilt on US HY.1 The rationale for the move was based on value, as spreads for all US IG credit tiers had tightened to our spread targets, which is not yet the case for HY. The message from our bottom-up US CHMs supports that recommendation. The combination of improving global growth and a Fed that will stay dovish until US inflation has sustainably moved higher paints a favorable backdrop for the relative performance of all US corporate debt versus Treasuries. However, given our expectation that US bond yields will continue to move higher over the next 6-12 months, the lower interest rate duration of US HY relative to IG also supports favoring the former over the latter (Chart 5). Chart 4Bottom-Up US HY CHM: Looking Better Than IG (!) Chart 5US Corporates: Stay Overweight HY & Neutral IG Euro Corporate Health Monitors: Some Cyclical Weakness Our bottom-up euro area CHMs are sending different messages for lower-rated and higher-quality issuers, similar to the divergence in our bottom-up US CHMs. For euro area IG, the gap between domestic and foreign issuers has been widening, with the former now in “deteriorating health” territory (Chart 6). Leverage has gone up for all issuers, with debt/equity ratios now above 100%, but the pace of increase has been faster for domestic issuers. Return on capital and profit margins for domestic issuers have declined since the start of 2018 alongside the prolonged slowing of euro area economic growth. For domestic euro area IG issuers, interest coverage has been steadily climbing since 2015 when the ECB went to negative rates and, more importantly, started its Asset Purchase Program that included corporate debt. Our bottom-up euro area CHMs are sending different messages for lower-rated and higher-quality issuers, similar to the divergence in our bottom-up US CHMs. For euro area HY, the signal from the bottom-up CHM is more positive for both domestic and foreign issuers (Chart 7), with both CHMs sitting just in the “improving health” zone. Leverage has declined, but profit-based metrics have worsened for both sets of issuers. Interest/debt coverage and liquidity, however, are far worse for domestic issuers than foreign issuers. Chart 6Bottom-Up Euro Area IG CHMs: Weak Growth Hitting Domestic Issuers Chart 7Bottom-Up Euro Area HY CHMs: Healthy, But Leverage Now Rising Within the euro area, our bottom-up IG CHMs for Core and Periphery countries have worsened over the past year, from healthy levels, with both above the zero line (Chart 8). Interest coverage is considerably stronger for Core issuers, although profitability metrics are remarkably similar. Short-term liquidity ratios have also fallen for both regional groups over the past year. We have maintained a moderate overweight stance on euro area corporates, both for IG and HY, since the summer of this year (Chart 9). This view was based on expectations that the European Central Bank (ECB) would ease monetary policy, not on a forecast that euro area growth would revive organically. That outcome came to fruition when the ECB cut rates in September and restarted asset purchases earlier this month. The ECB’s moves create a more supportive monetary backdrop (along with an undervalued euro) that will help keep euro area credit spreads tight – a trend that is reinforced by decent corporate health. Chart 8Bottom-Up Euro Area Regional IG CHMs: Heading In The Wrong Direction Chart 9Euro Area Corporates: Stay Overweight IG & HY Chart 10Relative Bottom-Up CHMs: Turning In Favor Of The US? We see no reason to alter our recommendations on euro area credit, based on our forecast of better global growth, with no change to the ECB’s ultra-accommodative monetary stance, in 2020. However, a stronger growth backdrop could benefit euro area HY performance more than IG, based on the comparatively healthier signal from the bottom-up euro area HY CHM. The gap between the combined IG/HY bottom-up CHMs for the US and euro area aligns with credit spread differentials between euro area and US issuers (Chart 10).2 latest trends show a narrowing of the gap between the US and euro area CHMs, suggesting relative corporate health favors US names (middle panel). At the same time, the stronger performance of the US economy, which is much less levered to global trade and manufacturing compared to Europe, continues to support US corporate performance versus euro area equivalents (bottom panel). UK Corporate Health Monitor: Some Improvement, Even With Brexit Uncertainty Despite the persistent uncertainty over the UK-EU Brexit negotiations that has weighed on UK economic confidence, our top-down UK CHM remains in the "improving health" zone (Chart 11). All of the individual components are contributing to the strength of the CHM, which even improved from those healthy levels in Q2/2019 (the most recent data available). A sustained easing of UK financial conditions – easy monetary policy alongside a deeply undervalued currency – have helped boost interest/debt coverage ratios by keeping UK corporate borrowing costs low. Top-down operating margins for UK non-financial firms have surprisingly increased and now sit just under 25%. Short-term liquidity remains solid with leverage holding at non-problematic levels. As we discussed in a recent Special Report, the UK economy has been holding up fairly well despite the political uncertainty that has driven a prolonged slowdown in productivity growth through weak business investment.3 The UK consumer has continued to spend, however, seemingly desensitized to the political drama, and the labor market has remained tight enough to support a decent pace of household income growth. Despite the persistent uncertainty over the UK-EU Brexit negotiations, our top-down UK CHM remains in the "improving health" zone. The near term performance of the UK's economy is highly dependent on the final result of Brexit negotiations. If a negotiated Brexit occurs, UK corporates can start to ramp up the capital spending that has been delayed due to the political uncertainty, which will eventually lead to an improvement in UK productivity growth and overall corporate performance. A strengthening pound and rising government bond yields, driven by markets unwinding Brexit risk premia, will mitigate some of that growth thrust, but the net effect will still boost the relative performance of UK corporate debt versus Gilts. There are still near-term political risks stemming from the UK parliamentary election next month, with the deadline for a UK-EU Brexit deal delayed until after the election. Thus, we continue to maintain only a neutral stance on UK IG corporates in our model bond portfolio, despite our overall bias to be overweight global corporate debt versus government bonds. We will reconsider that stance after we have more clarity on the final resolution of the Brexit uncertainty. At a minimum, however, we expect UK corporates to continue to deliver solid excess returns versus UK Gilts (Chart 12). Chart 11UK Top-Down CHM: Solid Improvement, Despite Brexit Chart 12UK Corporates: Stay Neutral Japan Corporate Health Monitor: A Further Cyclical Deterioration Our bottom-up Japan CHM remains in the "deteriorating health" zone, as has been the case since the start of 2018 (Chart 13).4 The message from the individual CHM components, however, is that this is a cyclical, not structural, deterioration in Japanese corporate credit quality, and from a very healthy starting point. Leverage, defined here as the ratio of total debt to the book value of equity, is slightly above 100%, well below the 100-140% range seen between 2006 and 2015. A similar trend exists for return on capital, which has dipped below 5% but remains high relative to its history (although very low by global standards). Operating margins, debt coverage and short-term liquidity are down from recent peaks but all remain well above the lows of the decade since the 2008 financial crisis. Interest coverage has suffered a more meaningful deterioration relative to its history. However, this is more a cyclical issue related to falling profits (the numerator of the ratio) rather than rising interest costs (the denominator), with the latter remaining subdued thanks to the Bank of Japan’s hyper-easy monetary policy. For the former, the cyclical momentum in Japan’s economy is not improving, despite some recent evidence that global growth may be stabilizing. According to the latest Tankan survey, Japanese manufacturers – who saw profits fall -31% on a year-over-year basis in Q2/2019 - reported a worse business outlook than previously expected, both for large and small firms. This is not surprising, as Japan’s economy remains highly levered to global growth and export demand, in general, and China, in particular. Yet the less trade-sensitive services sector has also weakened – forecasts of the Tankan non-manufacturing index have already rolled over and the services PMI dropped to 49.7 in October. Japan’s corporate spread has widened slightly (+10bps) since the beginning of this year (Chart 14), in contrast to the spread tightening seen in other major developed economy corporate bond markets. This is sign that the markets have responded to the slowing growth momentum in Japan with a bit of a wider risk premium. Yet despite that widening, Japanese corporates with small positive yields continue to generate positive excess returns (on a duration-matched basis) versus Japanese Government Bonds (JGBs); yields on the latter will remain anchored near zero by the Bank of Japan’s Yield Curve Control policy. Thus, we continue to recommend an overweight stance on Japanese corporates vs JGBs as a buy-and-hold carry trade, even with the softening in our Japan CHM. Chart 13Japan Bottom-Up CHM: Cyclical Deterioration Chart 14Japan Corporates: Stay Overweight Vs JGBs For Carry Canada Corporate Health Monitors: Continuous Improvement Our top-down and bottom-up Canadian CHMs indicate an improving trend in Canadian corporate health, with both remaining in the “improving” zone as of the latest data available from Q2/2019 (Chart 15). The cyclical components (return on capital and operating margins) have gradually improved over the past three years, but remain relatively weak compared to history. Leverage is rising (now above 120% in our bottom-up CHM), but interest/debt coverage ratios remain steady and, in the case of the bottom-up CHM, have outright improved over the past year. We reviewed the Canadian economy last week5 and concluded that a Bank of Canada interest rate cut was unlikely because of signs of improving domestic growth momentum at a time when core inflation was at the midpoint of the BoC’s 1-3% target range. Overall, Canadian growth has been resilient in the face of the 2019 global manufacturing downturn, and should re-accelerate in the next year led by a firm consumer with rebounding housing and business investment. This should help boost the cyclical components of our Canada CHMs, especially if some improvement in global growth helps lift demand for Canadian commodity exports. We also introduced a framework to analyze Canadian corporate bonds in a Special Report published in late August.6 We concluded that Canadian companies’ financial health remains a positive for corporate bond returns on a cyclical basis, but high leverage and mediocre profitability were longer-term concerns. We also noted that the higher credit quality of Canadian corporates, where only 40% of the investment grade index is rated BBB, made them more potentially appealing on a creditworthiness basis relative to the lower quality markets in the US (50% BBB share) and euro area (52%). We continue to recommend an overweight position in Canadian corporate debt relative to Canadian government bonds as a carry trade. We continue to recommend an overweight position in Canadian corporate debt relative to Canadian government bonds as a carry trade. Spreads have held in a well-established range of 100-200bps since the 2009 recession (Chart 16), even during periods when our CHMs were indicating worsening corporate health. Accommodative monetary conditions and relatively low Canadian interest rates will continue to make Canadian corporates relatively attractive, in an environment of decent growth and firm corporate health. Chart 15Canada CHMs: Still Healthy, Despite Slower Growth Chart 16Canadian Corporates: Stay Overweight Vs Canadian Govt. Debt Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Ray Park, CFA Research Analyst ray@bcaresearch.com Appendix 1: An Overview Of The BCA Corporate Health Monitors The BCA Corporate Health Monitor (CHM) is a composite indicator designed to assess the underlying financial strength of the corporate sector for a country. The Monitor is an average of six financial ratios inspired by those used by credit rating agencies to evaluate individual companies. However, we calculate our ratios using top-down (national accounts) data for profits, interest expense, debt levels, etc. The idea is to treat the entire corporate sector as if it were one big company, and then look at the credit metrics that would be used to assign a credit rating to it. Importantly, only data for the non-financial corporate sector is used in the CHM, as the measures that would be used to measure the underlying health of banks and other financial firms are different than those for the typical company. The six ratios used in the CHM are shown in Table 1 below. To construct the CHM, the individual ratios are standardized, added together, and then shown as a deviation from the medium-term trend. That last part is important, as it introduces more cyclicality into the CHM and allows it to better capture major turning points in corporate well-being. Largely because of this construction, the CHM has a very good track record at heralding trend changes in corporate credit spreads (both for Investment Grade and High-Yield) over many cycles. Table 1Definitions Of Ratios That Go Into The CHMs Top-down CHMs are now available for the US, euro area, the UK and Canada. The CHM methodology was extended in 2016 to look at corporate health by industry and by credit quality.7 The financial data of a broad set of individual US and euro area companies was used to construct individual “bottom-up” CHMs using the same procedure as the more familiar top-down CHM. Some of the ratios differ from those used in the top-down CHM (see Table 1), largely due to definitional differences in data presented in national income accounts versus those from actual individual company financial statements. The bottom-up CHMs analyze the health of individual sectors, and can be aggregated up into broad CHMs for Investment Grade and High-Yield groupings to compare with credit spreads. In 2018, we introduced bottom-up CHMs for Japan and Canada. With the country expansion of our CHM universe, we now have coverage for 92% of the Bloomberg Barclays Global Aggregate Corporate Bond Index (Appendix Chart 1). Appendix Chart 1We Now Have CHM Coverage For 92% Of The Developed Market Corporate Bond Universe Footnotes 1 Please see BCA Research Global Fixed Income Strategy Weekly Report, “How Sweet It Is”, dated November 6, 2019, available at gfis.bcareseach.com. 2 We only use the CHMs for euro area domestic issuers in this aggregate bottom-up CHM, as this is most reflective of uniquely European corporate credits. This also eliminates double-counting from US companies that issue in the euro area market that are part of our US CHMs. 3 Please see BCA Research Global Fixed Income Strategy Special Report, “United Kingdom: Cyclical Slowdown Or Structural Malaise?”, dated September 20, 2019, available at gfis.bcaresearch.com. 4 We do not currently have a top-down CHM for Japan given the lack of consistent government data sources for all the necessary components. 5 Please see BCA Research Global Fixed Income Strategy Weekly Report, “How Sweet It Is”, dated November 6, 2019, available at gfis.bcaresearch.com. 6 Please see BCA Research Global Fixed Income Strategy Special Report, “The Great White North: A Framework For Analyzing Canadian Corporate Bonds”, dated August 28, 2019, available at gfis.bcaresearch.com. 7 Please see Section II of The Bank Credit Analyst, “U.S. Corporate Health Gets A Failing Grade”, dated February 2016, available at bca.bcaresearch.com. Appendix 2: US Bottom-Up CHMs For Selected Sectors The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Martin Barnes and I spent last week visiting clients in Hong Kong and Singapore in celebration of BCA’s 70th anniversary. Martin has been with BCA Research for 32 years and has been a keen observer of market trends for much longer than that. It is always fascinating to hear his thoughts on the state of world affairs. I have spent this week visiting clients in Sydney and Melbourne. I made the case that global growth will accelerate next year. Stronger growth will pull down the U.S. dollar, while pushing up bond yields, equities, and commodity prices. EM and European stocks will begin to outperform their global benchmark. Cyclical equity sectors (including financials) will outperform defensives. What follows are my answers to some of the most common questions I have been receiving. Best regards, Peter Berezin, Chief Global Strategist Feature Q: What makes you confident that global growth will rebound? A: Three things. First, global financial conditions have eased significantly thanks largely to the dovish pivot of most central banks. Reflecting this development, credit growth has picked up. This should support economic activity in the months ahead (Chart 1). Second, the manufacturing downturn seems to be running its course, as excess inventories continue to be liquidated (Box 1). As we have noted before, manufacturing cycles tend to last about three years, with 18 months of weaker growth followed by 18 months of stronger growth (Chart 2). Given that the current downturn began in the first half of 2018, we are probably approaching a bottom in growth. Chart 1Lower Rates Should Help Spur Growth Chart 2A Fairly Regular Three-Year Manufacturing Cycle Third, while there will be plenty of bumps along the road, trade tensions are likely to continue easing. As a self-described master negotiator, President Trump has to produce a “tremendous” deal for the American people. Had he negotiated an agreement with China a year or two ago, he would currently be on the hook for showing that it resulted in a smaller trade deficit. But with the presidential election only a year away, he can semi-credibly claim that the trade balance will only improve after he is re-elected. For their part, the Chinese would rather grapple with Trump now than risk either having to negotiate with him during his second term (when he will be unconstrained by re-election pressures) or having to negotiate with Elizabeth Warren (who may insist on including stringent environmental and human rights provisions in any trade deal). Better the devil you know than the devil you don’t, as they say. Q: Will a ceasefire between the U.S. and China really be enough to boost business confidence? Don’t we need to see an outright rollback of tariffs? A: We do not know if any tariffs will be rolled back as part of the “phase 1” deal that is currently being negotiated. Right now, the U.S. has only agreed to cancel the previously announced October 15th tariff hike on $250 billion of Chinese imports. A Reuters news story earlier this week indicated that China is also asking the U.S. scrap its plan to levy tariffs on $156 billion of Chinese imports on December 15th and to abolish the 15% tariffs on $125 billion in imports which were imposed on September 1st.1 Chart 3China Is No Longer As Dependent On Trade With The U.S. As It Once Was While the removal of some tariffs would be a positive development, it is not a necessary condition for a global growth revival. Remember that U.S. exports to China account for only 0.5% of GDP while Chinese exports to the U.S. account for 3.4% of GDP (Chart 3). The numbers are even smaller when measured in value-added terms. That does not mean that the trade war is irrelevant. An out-of-control trade war could cause the global supply chain to break down, leading to significant economic disruptions. To the extent that a détente greatly reduces the odds of such an outcome, it justifies a meaningful upgrade to the probability-weighted economic outlook. Q: What’s your read on the Chinese economy right now? A: China’s growth data have been mixed. The Caixin manufacturing purchasing managers’ index rose to 51.7 in October, the best reading since December 2016. The new orders subcomponent reached the highest level since September 2013. Export orders rose back above 50, registering the largest month-on-month increase of any of the subcomponents. In contrast, the “official” National Bureau of Statistics (NBS) manufacturing PMI, which mainly samples larger, state-owned companies, remained below 50 and sank to the lowest level since February. The NBS nonmanufacturing PMI also weakened. It is worth noting that unlike most of the industries tracked by the NBS, the construction sector PMI moved back above 60 in October. This is consistent with industry data showing that sales of reinforced steel bars, a good proxy for property construction, have accelerated. Electricity consumption has also picked up, which often bodes well for industrial output (Chart 4). Policy has generally remained supportive: Bank reserve requirements have been cut. Benchmark interest rates should come down over the coming months. Credit growth surprised on the upside in September. While the acceleration in credit formation has been more muted this past year than in 2015-16, the credit impulse has nevertheless moved off its late-2018 lows. The Chinese credit impulse leads global growth by about nine months (Chart 5). Chart 4A Positive Sign For Chinese Growth Momentum Chart 5The Chinese Credit Cycle Should Support Global Growth Chart 6China Stepped Up Fiscal Stimulus In 2019 Less noticed is the fact that fiscal policy has been eased significantly. According to the IMF, the augmented budget deficit – which includes spending through local government financing vehicles and other off-balance sheet expenditures – is on track to reach nearly 13% of GDP in 2019, a bigger deficit than during the depth of the Great Recession (Chart 6). Looking out, we expect Chinese growth to rebound next year as the global manufacturing downturn ends and trade war tensions subside. Q: How much of a growth rebound can we expect in Europe? A: The slowdown in the euro area has been concentrated in Italy and Germany. In contrast, growth in Spain and France has held up relatively well (Chart 7). Looking out, Italian growth should rebound thanks to the 270 bps decline in 10-year bond yields that has taken place since October 2018 (Chart 8). German growth should also recover on an improvement in world trade and a stabilization in global auto production and demand. Chart 7Euro Area Growth: The Good, The Bad, And The Ugly Chart 8Lower Yields Should Lift Italian Growth Q: Will we see fiscal stimulus in Europe? A: Yes. Fiscal policy remains quite tight in the euro area, but it is starting to loosen at the margin. The fiscal thrust should reach 0.4% of GDP this year, the highest level since 2010 (Chart 9). We expect further modest fiscal easing in 2020, even against a backdrop of stronger domestic economic growth. Chart 9Euro Area Fiscal Stimulus Will Also Boost Growth Chart 10Germany's Competitive Advantage Against The Rest Of The Euro Area Is Deteriorating Germany has been reluctant to increase its own budget deficit in the past. However, there are at least two reasons why this attitude may slowly change. First, there are growing calls within Germany for more spending on public infrastructure, including on ”green” measures to mitigate climate change. The fact that Germany can issue debt at negative rates only incentivizes fiscal easing. If you can get paid to issue debt, why not do it? Second, relatively fast wage growth has caused Germany to become less competitive against its neighbors over the past eight years. As a result, Germany’s trade surplus with the rest of the euro area has fallen in half (Chart 10). A shrinking trade surplus will require a bigger budget deficit to compensate for the loss of aggregate demand. Q: Is A “No Deal” Brexit still a risk? A: No. Westminster and the British Supreme Court have both rebuked Prime Minister Boris Johnson’s threat of a “no deal” Brexit. This means that the only outcome that would unsettle markets – a disorderly U.K. exit from the EU – is practically off the table. Two options remain: An orderly Brexit in which an eventual trade deal minimizes tariffs, or another referendum. There is no appetite for a no-deal exit. Furthermore, if another referendum on EU membership were held today, the remain side would probably win (Chart 11). Chart 11Brexit Angst: A Case Of Bremorse Q: Is the Fed done cutting rates? A: Yes. The FOMC statement removed the promise to “act as appropriate to sustain the expansion” and replaced it with a more neutral pledge to “monitor the implications of incoming information for the economic outlook”. If there were any ambiguity left about what this meant, Chair Powell squelched it by noting in his press conference that “monetary policy is in a good place” and “the current stance of policy [is] likely to remain appropriate.” This week’s “insurance cut” brings the total for this year to 75 bps. This is exactly the same amount of easing the Fed delivered in 1995/96 and 1998 — two episodes that are widely seen as successful mid-cycle course corrections. Today’s strong employment report and uptick in the ISM manufacturing index provide further evidence that the U.S. economy is on the right track. If U.S. and global growth continue to pick up as we expect, there will not be any need to cut rates further. Q: When can we expect the Fed to start hiking rates again? Chart 12Inflation Expectations Are Too Low A: Probably not until December 2020 at the earliest. This is partly because the Fed will want to stay out of the political fray leading up to the presidential election (perhaps wishful thinking). Arguably more important, the Fed, along with most market participants, has convinced itself that the neutral rate of interest is very low. If that is truly the case, raising rates is a risky strategy because it could cause growth to weaken at a time when inflation expectations are still below the Fed’s comfort zone (Chart 12). In his recent press conference, Powell seemed to go out of his way to stress that he would not make the same mistake he did last October when he said rates were “a long way from neutral”. Most notably, he said this week that the FOMC “would need to see a really significant move up in inflation that is persistent before we even consider raising rates to address inflation concerns.” Q: How worried should equity investors be about the prospect of President Warren? A: While Elizabeth Warren would not be a welcome treat for shareholders, she probably would not be a disaster either. Right now she is trying to elbow Bernie Sanders out of the race in order to lock up the “progressive” vote. Thus, it is not surprising that she has dialed up the far-left rhetoric. If Warren succeeds in securing the Democratic Party nomination, she will pivot to the centre. Remember this is the same person who said last year she was “a capitalist” and “I love what markets can do… They are what make us rich, they are what create opportunity.”2 Considering that financial sector reform has been the focus of Warren’s academic and legislative career, bank shareholders are understandably worried about what a Warren presidency would entail. They probably shouldn’t be. Banks today operate more like staid utilities than the reckless casinos they were prior to the financial crisis. A lot of the rules and regulations that Warren champions have already been implemented in one guise or another. In fact, it would not be a stretch to say that had these rules been in place 15 years ago, the share prices of many financial institutions would be a lot higher today (especially the ones that went under!). Lastly, one should keep in mind that the U.S. political system has numerous checks and balances. Even if Elizabeth Warren did want to pursue a radical agenda, she would be stymied by moderate Democrats and a Senate which, more likely than not, will remain in Republican control. Q: Taking everything you said on board, how should investors position themselves over the next 12 months? A: Despite the risks facing the global economy, investors should continue to overweight stocks relative to bonds in a balanced portfolio. A rebound in global growth next year will give corporate earnings a lift. As a countercyclical currency, the U.S. dollar is likely to weaken in an environment of improving global growth (Chart 13). The combination of stronger growth and a weaker dollar will boost commodity prices (Chart 14). Chart 13The Dollar Is A Countercyclical Currency Chart 14Dollar Weakness Is A Boon For Commodities Cyclical equity sectors normally outperform defensive sectors when the global economy is strengthening and the dollar is weakening (Chart 15). Chart15ACyclical Stocks Will Outperform If The Dollar Weakens Chart 15BCyclical Stocks Are More Attractive Than Defensives We would include financials in our definition of cyclical sectors. As global growth improves, long-term bond yields will increase at the margin. Since central banks are in no hurry to raise rates, yield curves will steepen. This will boost bank net interest margins, flattering profits and share prices (Chart 16). Emerging market and European stocks have more exposure to cyclical sectors than U.S. stocks. Thus, it stands to reason that EM and European equities will outperform their U.S. peers over the next 12 months (Chart 17). Chart 16Steeper Yield Curves Will Benefit Financials Chart 17EM And Euro Area Equities Usually Outperform When Global Growth Improves Non-U.S. stocks also have the advantage of being cheaper, even if adjusted for differences in sector weights. U.S. equities currently trade at a forward PE ratio of 18, compared to 13 for non-U.S. stocks. Since interest rates are generally lower outside the U.S., the equity risk premium is especially wide for non-U.S. stocks (Chart 18). Chart 18Equity Risk Premia Remain Quite High Box 1 Evidence of Inventory Liquidation In The Manufacturing Sector U.S. (October 2019): “Finally, despite a renewed rise in input buying, the stronger increase in new business meant firms increasingly dipped into stocks to ensure new orders were fulfilled in a timely manner. Therefore, pre-production inventories fell at the quickest rate for three months and stocks of finished goods decreased slightly.” Markit “The [inventory] index contracted for the fifth straight month, but at a slower rate. Improvements in new orders and stocking for the fourth quarter both contributed positively to the index compared to September” ISM (Institute for Supply Management) Germany (October 2019): “However, weighing on the index were faster decreases in employment and stocks of purchases, alongside a more marked improvement in supplier delivery times.” Markit U.K. (October 2019): “A number of firms revisited their Brexit preparations during October, leading to higher levels of input purchasing and a build-up of safety stocks. Growth in inventories of finished goods and purchases were at six-month highs, but remained below the survey-record rates reached during the first quarter.” Markit Japan (October 2019): “A reluctance to hold items in stocks was also signalled by simultaneous draw-downs to pre- and post-production inventories during the latest survey period. In fact, rates of depletion in both cases accelerated during the month, with stocks of finished goods falling at the fastest rate since survey data were first collected 18 years ago.” Markit Canada (October 2019): “Latest data signalled a marginal accumulation of preproduction inventories across the manufacturing sector. In contrast, stocks of finished goods were depleted for the first time in three months. A number of survey respondents commented on efforts to boost cash flow by streamlining their post-production inventories.” Markit China (October 2019): “Improved client demand led firms to expand their purchasing activity, with the rate of growth the quickest since February 2018. This contributed to a further rise in stocks of inputs, albeit marginal. Inventories of finished goods meanwhile declined amid reports of the greater use of stocks to fulfil orders.” Markit Taiwan (October 2019): “Stocks of both pre- and postproduction goods contracted at accelerated rates, with the latter falling solidly overall.” Markit Korea (October 2019): “Elsewhere, latest survey data highlighted a strong drive towards cost cutting, with firms clearing their existing stocks of both inputs and finished goods at accelerated rates.” Markit India (October 2019): “Both pre- and post-production inventories decreased in October. The fall in the latter was sharper and the quickest in 16 months.” Markit Russia (October 2019): “Finally, firms reduced their purchasing activity further as they supplemented production through the use of preproduction inventories. Stocks of finished goods also fell amid lower client demand and efforts to run down stores.” Markit Turkey (October 2019): “A muted easing of purchasing activity was recorded in October, while stocks of both purchases and finished goods were scaled back.” Markit Brazil (October 2019): “As a result, stocks of purchases fell at the quickest rate in 16 months. Post-production inventories likewise decreased to the greatest extent since mid-2018 during October. According to panel members, the fall was due to sales growth.” Markit Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1Please see David Lawder, and Andrea Shalal, “U.S., China say they are 'close to finalizing' part of a Phase One trade deal,” Reuters (October 25, 2019); and Alexandra Alper, and Doina Chiacu,"Trump: 'ahead of schedule' on China trade deal," Reuters (October 28, 2019). 2Please see John Harwood, “Democratic Sen. Elizabeth Warren: ‘I am a capitalist’ – but markets need to work for more than just the rich,” CNBC (July 24, 2018). Strategy & Market Trends MacroQuant Model And Current Subjective Scores Strategic Recommendations Closed Trades
In lieu of the next weekly report I will be presenting the quarterly webcast ‘The Japanification Of Europe: Should We Fear It, Or Celebrate It?’ on Monday 4 November at 10.00AM EST, 3.00PM GMT, 4.00PM CET, 11.00PM HKT. As usual, the webcast will take a TED talk format lasting 18 minutes, after which I will take live questions. Be sure to tune in. Regards, Dhaval Joshi Highlights Global and European growth is experiencing a welcome rebound. Favour a cyclical investment stance, albeit tactical – as there is no visibility in the growth rebound beyond early 2020. Close the overweight to healthcare versus industrials at a small profit. Upgrade Sweden and Spain to overweight, and Norway to neutral. Downgrade Denmark to underweight, and Ireland to neutral. Expect heightened volatility in sterling in the build up to a highly ‘non-linear’ UK election. Fractal trades: 1. long oil and gas versus telecom; 2. long tin. Feature Global and European growth is experiencing a welcome rebound. This we can see from the best real-time indicators of activity, such as the ZEW sentiment, IFO expectations and of course the equity and bond markets (Chart of the Week). Nevertheless, investors make three very common mistakes in interpreting, predicting, and implementing such rebounds. This week’s report describes these three mistakes and the underlying realities. Chart of the WeekGrowth Is Experiencing A Welcome Rebound Mistake #1: Real-Time Indicators Do Not Lead The Market Reality #1: In the short term, markets move in lockstep with indicators such as the ZEW sentiment, IFO expectations, and PMIs (Chart I-2). Chart I-2Economic Indicators Do Not Lead The Markets... Having said that, the evolution of economic indicators can still provide a useful long-term investment signal. If an indicator – like IFO expectations – tends to revert to its mean, and is now near its historical lower bound, the scope for an eventual move up is greater than the scope for a further move down.1 Based on such a reversion to the mean, we are maintaining a structural overweight to the DAX versus the German long bund (Chart I-3). Chart I-3...But Depressed Performances Have Scope For Long-Term Upside But to reiterate, in the short term, the market moves in lockstep with the real-time economic indicators. Hence, to get a useful short-term investment signal, we need to predict where these indicators will be in the coming months – in other words, to predict whether growth will continue to accelerate. In the short term, the market moves in lockstep with real-time economic indicators. Which brings us neatly to the second mistake. Mistake #2: When Financial Conditions Ease, Growth Does Not Necessarily Accelerate Reality #2: It is not the change of financial conditions but rather its impulse – the change of the change – that causes growth to accelerate or decelerate. For example, a 0.5 percent decline in the bond yield decline will trigger new borrowing through, inter alia, an increase in the number of mortgage applications. The new borrowing will add to demand, meaning it will generate growth. But in the following period, a further 0.5 percent decline in the bond yield will generate the same additional new borrowing and thereby the same growth rate. The crucial point being that if the decline in the bond yield is the same in the two periods, growth will not accelerate. Growth will accelerate only if the first 0.5 percent bond yield decline is followed by a bigger, say 0.6 percent, decline – meaning a tailwind impulse. But growth will decelerate if the first 0.5 percent decline is followed by a smaller, say 0.4 percent, decline – meaning a headwind impulse. To repeat, the counterintuitive thing is that for a growth acceleration it is not the change in the bond yield that is important but rather its impulse. There are four impulses that matter for short-term growth: The bond yield 6-month impulse. The credit 6-month impulse. The oil price 6-month impulse (for oil importing economies like Germany). The geopolitical risk impulse. To be clear the geopolitical risk impulse is not an impulse in the technical sense, but it is a similar concept: is the number of potential geopolitical tail-events going up or down? In the fourth quarter, our subjective answer is down. The Brexit deadline has been pushed back to January 31 2020; the new coalition government in Italy has removed Italian politics as an imminent tail-event; and the US/China trade war and Middle East tensions are most likely to be in stasis. Turning to the other impulses, the credit 6-month impulse should briefly rebound in the fourth quarter following the rebound in the global bond yield 6-month impulse (Chart I-4). All of this favours a cyclical investment stance – albeit tactical, because there is no visibility in this growth rebound beyond early 2020. Chart I-4The Credit 6-Month Impulse Should Briefly Rebound Meanwhile, the recent evolution of the oil price 6-month impulse should provide an additional short-term tailwind for oil importing economies (Chart I-5). Justifying a near-term overweight stance to the cyclical heavy German stock market within a European or global equity portfolio. Chart I-5The Oil Price 6-Month Impulse Should Help Oil Importing Economies Which brings us to the third mistake. Mistake #3: Major Stock Markets Are Not Plays On Their Economies Of Domicile Reality #3: Major stock markets are dominated by multinational corporations, and such companies are plays on their global sectors, rather than the country in which they have a stock market listing. Hence, a stock market’s relative performance is predominantly a play on its distinguishing overweight and underweight ‘sector fingerprint’. What confuses matters is that sometimes the sector fingerprint happens to align with the tilt of the domicile economy. Germany has an exporter heavy stock market and an exporter heavy economy while Norway has an oil heavy stock market and an oil heavy economy, so in these cases there is a connection between the stock market and the economy. But in most instances, there is no alignment: the connection between the UK stock market and the UK economy is minimal, and the same is true in Spain, Denmark, Ireland, and most other countries. When bond yields were declining most sharply, and growth was decelerating, it weighed on cyclical sectors such as industrials and banks versus the more defensive sectors such as healthcare. Banks suffered doubly because the flattening (or inverting) yield curve also ate into their margins. But if the sharpest decline in bond yields has already happened, it suggests that cyclicals could experience a burst of outperformance, at least for a few months (Chart I-6). Hence, today we are closing our four month overweight to healthcare versus industrials at a small profit. Chart I-6If The Sharpest Decline In Bond Yields Is Over, Cyclicals Could Outperform Based on sector fingerprints, this also necessitates the following changes to our country allocation: Overweight banks versus healthcare means overweight Sweden versus Denmark (Chart I-7). Chart I-7Long Sweden Versus Denmark = Long Financials And Industrials Versus Biotech Overweight banks means overweight Spain (Chart I-8). Chart I-8Long Spain = Long Banks Meanwhile, removing our underweight to the cyclical oil sector means removing the successful underweight to Norway (Chart I-9). And indirectly, it means removing the equally successful overweight to Ireland, given its high weighting to Airlines (Chart I-10). Chart I-9Long Norway = Long Oil And Gas Chart I-10Long Ireland = Long Airlines Bonus Mistake: You Can Not Hit A Point Target In A Non-Linear System Boris Johnson said that he “would rather be dead in a ditch” than miss the October 31 deadline for delivering Brexit. Well Johnson had to ditch his ditch. Why? Because the UK’s parliamentary arithmetic has made Brexit an inherently non-linear system, and you cannot hit a point target in a non-linear system. Boris Johnson had to ditch his ditch. In a non-linear system a tiny change in an input might have no impact on the output, or it might have a huge impact on the output. The Brexit process is inherently non-linear because a tiny shift in parliamentary votes one way or another, or a tiny shift in the tabled amendments to laws one way or another has had a huge impact on the outcome. That’s why it proved impossible for Johnson to hit his point target of delivering Brexit by October 31. Attention now shifts to another non-linear system – the upcoming UK general election. The UK’s first past the post electoral system is designed for a head-to-head between two dominant parties. But right now, there are five parties in play – Labour, Liberal Democrat, Conservative, Brexit, plus the SNP in Scotland. Mathematically, this creates the possibility of ten types of swings, compared with the usual single swing between Labour and Conservative. Making the outcome of the election highly sensitive to a tiny shift in votes either way in ten different directions. The UK general election is a non-linear system. In The Pound Is A Long Term Buy (And So Are Homebuilders) we initiated a structural long position in the undervalued pound.2 Given that our overweight to the international focused FTSE100 versus the domestic focussed FTSE250 is effectively an inverse play on the pound, it is inconsistent with our long-term view on the currency (Chart I-11). Nevertheless, over the course of the election campaign we expect heightened volatility in sterling as the non-linearity of the election outcome becomes clear. Hence, we await an upcoming better opportunity to remove our overweight FTSE100 versus FTSE250 position. Chart I-11Long FTSE250 Versus FTSE100 = Long Pound Fractal Trading System* There are two recommended trades this week. The underperformance of US oil and gas versus telecom is ripe for a technical rebound based on its broken 130-day fractal structure. Go long US oil and gas versus telecom, setting a profit target and symmetrical stop-loss at 8 percent. The recent sell-off in tin is undergoing a similar technical bottoming process. Go long tin, setting a profit target and symmetrical stop-loss at 5 percent. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-12US: Oil & Gas Vs. Telecom Chart I-13Tin The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com. Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 In technical terms, if the time-series is ‘stationary’, it must eventually rebound from its lower bound. 2 Please see the European Investment Strategy Weekly Report, "The Pound Is A Long-Term Buy (And So Are Homebuilders)," dated October 17, 2019 available at eis.bcaresearch.com Fractal Trading System Cyclical Recommendations Structural Recommendations Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II_8Indicators To Watch - Interest Rate Expectations